Karl Brunner and Allan Meltzer: From Monetary Policy to Monetary History to Monetary Rules* Prepared for the Conference “Karl Brunner and Monetarism” Swiss National Bank, Zurich, Switzerland, October 29-30, 2018 Michael D Bordo Rutgers University, Hoover Institution, and NBER Economics Working Paper 19104 HOOVER INSTITUTION 434 GALVEZ MALL STANFORD UNIVERSITY STANFORD, CA 94305-6010 March 1, 2019 Karl Brunner and Allan Meltzer were pioneer monetarists whose work in the 1960s and 1970s challenged the prevailing Keynesian orthodoxy. A major part of their work was a critique of the Federal Reserve System’s monetary policy strategy from the 50s leading to the Great inflation. This paper explores the nexus between Brunner and Meltzer’s earlier work in a report prepared for the US congress in 1964 on the System’s discretionary counter cyclical policy in its first fifty years of existence, and Allan Meltzer’s monumental two volume A History of the Federal Reserve (2003, 2009). Many of the themes in the early report reappeared in A History. A key theme in the 1964 monograph was a critique of the Fed’s use of the Net Free Reserves doctrine which had evolved in the 1950s from the earlier Burgess Rieffler Strong doctrine which guided Fed policy in the 1920s and 1930s. which the authors argued explained the Fed’s policy mistakes leading to the Great Contraction. They posit the case that their monetarist approach based on the money supply, monetary base and money multiplier could have greatly improved the Fed’s performance from the 1920s to the 1960s.The 1964 monograph was a key building block for their later work in monetary theory and policy including their critique of Keynes, the importance of policy uncertainty and the case for a monetary base rule. Keywords: Federal Reserve, Net Free Reserves Doctrine, Monetary Rules, Allan Meltzer, Karl Brunner, Monetary Policy JEL Codes: E52, E58, N12 The Hoover Institution Economics Working Paper Series allows authors to distribute research for discussion and comment among other researchers. Working papers reflect the views of the author and not the views of the Hoover Institution. * For helpful comments I thank Alan Blinder, Ben Friedman, Hugh Rockoff and David Wheelock. 1. Introduction Karl Brunner and Allan Meltzer were pioneer monetarists along with Milton Friedman, Anna Schwartz and Clark Warburton1. Their path breaking work in the 1960s and 1970s on the relationship between the money supply and output and prices based on the Quantity Theory of Money challenged the prevailing Keynesian orthodoxy. They also effectively criticized the monetary policy strategy of the Federal Reserve System and contributed to the sea change in policy making that occurred under the chairmanship of Paul Volcker in 1979. Their work encompassed monetary theory, monetary policy and monetary history. In this paper I explore the nexus between their earlier work in a report prepared in 1964 for the U.S. Congress evaluating the Federal Reserve’s discretionary countercyclical monetary policy strategy in its first 50 years, and Allan Meltzer’s later 2003 and 2010 monumental two volume book A History of the Federal Reserve and finally to their case for monetary rules. Many of the key themes in the later Meltzer books were developed earlier by Brunner and Meltzer in their 300 page monograph. These included: the role of the Federal Reserve’s incorrect monetary framework in precipitating major failures in monetary policy, especially the Great Contraction from 1929 to 1933 (and later after the monograph was published, the Great Inflation from 1965 to 1983). Brunner and Meltzer blamed the Fed for following the flawed Free Reserves Doctrine which in turn was based on the earlier Burgess Rieffler (Strong) doctrine developed in the 1920s2. Brunner and Meltzer (1964) argue that a superior framework based on the monetary base, money supply multiplier and the money supply would have avoided many of these mistakes. To make their case against the Fed’s framework the monograph is full of discussions 2 of episodes of Federal Reserve Policy from the 1920s to the 1960s. These episodes appear later in Meltzer’s History of the Federal Reserve. In the 1964 monograph they do not explicitly make the case for a monetary rule as their mandate was to critically evaluate the Fed’s discretionary counter cyclical policies. In their later work they make the case for monetary rules based on the Fed’s flawed use of forecasts in conducting discretionary monetary policy. This line of research led to Allan Meltzer’s 1987 monetary base rule with feedback from the real economy and later to Meltzer’s advocacy of the Taylor Rule. Brunner and Meltzer (1964) also touched base on themes that would appear in their later work including the role of information and uncertainty and the distinction between permanent and transitory shocks. Another theme that first appears in the 1964 monograph is a critique of the concept of the liquidity trap that was at the heart of Keynesian doctrine. Brunner and Meltzer’s work on the liquidity trap appeared later in their well-known 1968 JPE article. This work fed into Brunner and Meltzer’s Mattioli Lectures (1983) and Meltzer’s (1988) book on Keynes. Brunner and Meltzer do not explicitly develop the monetary policy transmission mechanism in their 1964 monograph but the evidence that they marshall against the Fed’s policy helped their later work on the Brunner and Meltzer model in the 1970s and 1980s and later their work on the credit channel of monetary policy in the 1990s. The paper is structured as follows. Section 2 focuses on the 1964 monograph. I develop four themes: their general framework; their critique of the Free Reserves doctrine; their alternative monetary base, money multiplier approach; and their empirical and historical evidence. Section 3 highlights the main themes in Allan Meltzer’s A History of the Federal Reserve. In section 4 I 3 explore the connection between the 1964 monograph and the later Rules versus Discretion debate. Section 5 concludes with some of the lessons from Brunner and Meltzer’s treatment of theory, empirical evidence and narrative monetary history. 2. Brunner and Meltzer (1964) on Federal Reserve Monetary Policy In 1964 Karl Brunner and Allan Meltzer issued a monograph commissioned by Chairman Wright Patman of the Congress Committee on Banking and Currency. In this lengthy report the authors critically evaluated the framework and operations of the Federal Reserve System in its first fifty years of operation. The questions that the authors posed were: 1) What was the key idea in the Federal Reserve’s policy framework?; 2) How did their framework translate into policy?; 3) How did the Fed’s framework fare when tested against the experience?3 The Study was divided into 4 sections: 1. Some General Features of the Federal Reserve Approach to Policy: 2. Free Reserves; 3. The Monetary Base and Money Multiplier Approach; 4. Evidence on the Relationship between the Monetary Base and the Money Supply. 2.1 General Features of the Federal Reserve’s Approach to Monetary Policy In this section of the monograph, Brunner and Meltzer present an overview of the findings of their study. Their evaluation was based on the record available from the Federal Open Market Committee (FOMC), the staffs of the Board of Governors and the Federal Reserve Banks. It was also based on a questionnaire the authors sent to the FOMC members and Reserve bank Presidents. The authors spell out the Fed’s 4 framework, criticize it, and compare it both with data and historical experience. They then compare the Fed’s framework to their own which is based on the monetary base and the money multiplier. The key conclusion derived from this study is that the Federal Reserve did not have an effective monetary policy framework. It did not have a viable analysis linking their monetary policy actions to the money supply. Because the Fed did not have an adequate framework of how its policy affects the money supply it did not follow good monetary policy (Brunner and Meltzer 1964a page 9). Later in the monograph the authors attribute the Fed’s flawed policy framework to its adherence to various versions of one developed by W.W Rieffler in the 1920s and later extended in the 1930s and 40s by W. Randolph Burgess and Emmanuel A. Goldenweisser. The reasons given for the Fed’s failure as developed throughout the monograph are: 1. The Fed’s short-term emphasis (what Allan Meltzer later called “short termism”). 2.The Fed viewed the monetary process from the perspective of a single bank rather than the banking system as a whole. Brunner and Meltzer argued that the Fed’s concern with short-term events had driven out the long-term research needed to develop an effective framework and moreover, a key reason why the Fed mainly focused on short-term factors is because it did not have an understanding of the connection between monetary policy and the money supply or of the money supply to real income and the price level. The way the Fed operated when Brunner and Meltzer were writing was to adjust commercial banks reserve positions to affect the money market. The Fed’s short-term 5 focus was on the “feel and tone” of the market and the level of free reserves. This they argued led the FOMC to give conflicting goals to the Manager of the FOMC desk which in turn gave him considerable discretionary power. In the Fed’s view, bank reserves and the federal funds rate reacted to market forces and had a large random component. The Manager of the Desk had to separate random from systematic elements.